Adjusted and Unadjusted Beta
Betas calculated purely based on historical data are unadjusted betas. However, this beta estimate based on historical estimates is not a good indicator of the future. This is also called the beta instability problem.
Statistically, over time betas may exhibit mean reverting properties as extended periods significantly above 1 (one) may eventually decline and betas below one may revert toward 1.
Therefore analysts may apply models to create an adjustment calculation for the historical beta and use this adjusted beta to calculate the expected return for the security.
The generalized formula for adjusted beta can be presented as follows:
Adjusted Beta Β = α0 +α1Βi,t-1
Where, α0 + α1 = 1
Because of the mean reverting property of beta, the adjusted beta will move closer to 1. If the historical or unadjusted beta is greater than 1, then the adjusted beta will be lesser that unadjusted beta and closer to 1, and vice versa.
Let’s take an example to understand this.
Assume that the historical beta for a company is 1.5. the adjusted beta formula for the company is 3/4 + 1/4 Βt-1
Adjusted beta = 3/4 + 1/4 * 1.5 = 1.125
The larger the value of α0, the faster the adjusted beta will move towards 1.
- CFA Level 2: Portfolio Management – Introduction
- Mean-Variance Analysis Assumptions
- Expected Return and Variance for a Two Asset Portfolio
- The Minimum Variance Frontier & Efficient Frontier
- Diversification Benefits
- The Capital Allocation Line – Introducing the Risk-free Asset
- The Capital Market Line
- CAPM & the SML
- Adding an Asset to a Portfolio – Improving the Minimum Variance Frontier
- The Market Model for a Security’s Returns
- Adjusted and Unadjusted Beta
- Multifactor Models
- Arbitrage Portfolio Theory (APT) – A Multifactor Macroeconomic Model
- Risk Factors and Tracking Portfolios
- Markowitz, MPT, and Market Efficiency
- International Capital Market Integration
- Domestic CAPM and Extended CAPM
- Changes in Real Exchange Rates
- International CAPM (ICAPM) - Beyond Extended CAPM
- Measuring Currency Exposure
- Company Stock Value Responses to Changes in Real Exchange Rates
- ICAPM vs. Domestic CAPM
- The J-Curve – Impact of Exchange Rate Changes on National Economies
- Moving Exchange Rates and Equity Markets
- Impacts of Market Segmentation on ICAPM
- Justifying Active Portfolio Management
- The Treynor-Black Model
- Portfolio Management Process
- The Investor Policy Statement